Coca-Cola still has a winning recipe

If you ever doubt the importance of branding to consumer stocks, just think of Coca-Cola (US:KO). Indeed, with Christmas approaching, you'll be hard pushed to find a better example of a company’s marketing success than the association of Santa Claus with Coca-Cola red.

The soft drinks manufacturer enjoys some of the strongest brand equity of any stock. Its portfolio includes Fanta, Sprite and Diet Coke alongside its biggest-selling classic Coke beverage. Out of a mixture of design and necessity, the company has also branched out over the years – to give an inexhaustive list – into coffee, smoothies, and water via brands such as Costa Coffee, Innocent Smoothies, and Dasani.

According to brand consultancy Interbrand’s latest annual report, Coca-Cola has the sixth-strongest brand in the world of any company, and is the standout leader among soft drinks firms. Its market penetration is global and deep, with distribution in every country on earth bar Cuba and North Korea.

Brand strength, combined with global operations built up over many decades (including over 200 bottling partners and 900 bottling plants) is Coca-Cola’s economic moat. This is what protects it from, and causes problems for, competitors.   

Coca-Cola’s 2020 results – its fiscal year runs to 31 December – fell to a pandemic-induced nadir. Net operating revenue plunged by over 11 per cent as restrictions hit the restaurants, bars and other businesses that normally contribute about half of the company’s sales.

It is yet unclear what the impact of the new Omicron coronavirus variant will be on the company. New social and economic restrictions could stymie growth into next year. But the signs of recovery are promising. The latest results, for the quarter to 1 October, were better than expected and allowed the company to raise full-year guidance.

Volumes were ahead of 2019 and operating income grew 26 per cent as the easing of restrictions improved trading conditions. Revenue for the first nine months of the year topped $29bn (£22bn), putting the company well on track to exceed 2019’s top line.

This recovery comes in the context of a strategic transformation which management hopes will drive future growth. ‘Master brand’ products have been reduced to around 200 and the company’s operational structure is being reorganised. RBC Capital Markets analysts said they expect this to “manifest in better market share and top line, with evidence starting to become clear in 2022”.

Amid this realignment, Coca-Cola has just made its biggest ever acquisition. Last month, the remaining 85 per cent of sports drink company Bodyarmor was purchased for $5.6bn. This offers “significant potential for long-term growth”, given the target's 50 per cent current growth rate and $1.4bn in annual retail sales.

A deep dive into Coca-Cola’s financials reveals a business that is excellent at cash generation. For the nine months to 1 October, the company posted $8.5bn of free cash flow, a $3bn jump from the comparative. A cash conversion rate of 117 per cent and a five-year free cash flow yield average of 20 per cent is not to be sniffed at.

Such cash metrics have underpinned a dividend that has climbed for 59 consecutive years. A solid yield of around 3 per cent must be set against consistent rather than mind-blowing growth in cash returns: the annual payout per share rose from 1.32¢ to 1.64¢ between 2015 and 2020.

Other key metrics point to a solid and well-functioning business. The gross margin averaged 61 per cent over the five years to December 2020. Return on capital employed, a ratio that assesses how profitable a company is from all its debt and equity, sits at over 15 per cent.

Coca-Cola’s valuation looks undemanding when set against competitors. The shares trade on a 12-month forward price/earnings ratio of 22, based on consensus forecasts – which is a discount to both PepsiCo (US:PEP) and Nestlé (CH:NESN). Given the company’s economic moat and growth prospects, this looks attractive.

We can’t see into the ‘chamber of the secret formula’ in the Atlanta vault where Coca-Cola’s recipe is secured. But excellent fundamentals mean we can be reasonably sure of the company's ability to grow returns.

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